Tackling treaty-shopping

SummaryIndia is taking on treaty-shopping by tailoring ‘limitation of benefits’ clauses in the tax treaties according to tax jurisdictions

Post economic liberalisation, India is keen to receive huge capital inflows but at the same time does not want to lose the grip on its share of taxation from the income generated in India. In order to avoid double taxation and to attract more investments, India has entered into double tax avoidance agreements (tax treaties) with several countries. As per the Income Tax Act, 1961, if a tax treaty applies to a taxpayer, provisions of the Act shall apply to the extent they are more beneficial to that taxpayer. However, tax treaties have been misused by the taxpayers for tax avoidance/evasion purpose. One such example is interposing a company in the low tax jurisdiction only for the purpose of availing the tax treaty benefit. In other words, it is called treaty-shopping.

Typically, the treaty-shopping is countered under the Act by General Anti-Avoidance Rules or Specific

Anti-Avoidance Rules. However, under the tax treaties, the same has been countered by anti-treaty-shopping provisions like limitation of benefit (LOB) clause and/or beneficial ownership provisions. Generally, the LOB clause restricts availing of the treaty benefits by a conduit entity or an entity which has been formed for the purposes of treaty-shopping. It also restricts entities who attempt to claim double non-taxation; for example, LOB clause under India-Singapore tax treaty. In other words, LOB clause limits the benefits of tax treaties to legitimate residents of the other country. Basically, LOB clause is designed to test the substance of the claimant to the tax treaty. Accordingly, it prevents treaty-shopping and tax avoidance. The LOB clause in the treaty consists of various tests which need to be fulfilled in order to avail the treaty benefit; for example, main purpose of transaction, bona-fide business activity, qualified person test, stock exchange test, threshold for expenditure test, etc.

The LOB concept in tax treaties was introduced by the US while it was non-existent in OECD as well as UN Model Conventions. The US Model Tax Convention (of 1996 and 2006) has detailed LOB provisions in Article 22 of the Convention. In September 1989, India entered into a tax treaty with the US which incorporated the LOB clause for the first time in Indian treaties consisting of various objective tests.

In January 2003, the report of the working group in India on ‘non-resident taxation’ recommended that in future negotiations, provisions relating to anti-abuse/LOB may be incorporated in the tax treaties. In last decade, India has